Financial Management: Journal Of Banking And Finance Essay

Calculate the Weighted Average Cost of Capital using an appropriate technique.
Explain your calculations and the judgements you made in arriving at your answer.
Calculate gearing ratios and describe any difficulties in doing so.
Analyse your findings with reference to capital structure theory.
Provide a recommendation to the Board on the firm’s current capital structure.
Provide a reflection on your work and your report.

Answer:

Introduction:

Capital structure is still a puzzle for the financial analyst, investors and the financial managers of an organization. The main purpose of this report is to evaluate the capital structure theories and on the basis of that evaluate the capital structure of Altium Limited. Capital structure is the proportion of entire sources on the basis of that, a company has raised the funds such as equity, debt, preferences share etc. Capital structure is depicts as debt degree in the capital or financing of a business (Abor, 2005). Capital structure is an approach to identify the business activities and the risk and cost position of an organization, capital structure of an organization affects the entire profitability level and efficiency of an organization.

In the given report, capital structure of Altium Limited has been evaluated. For identifying the capital structure position, weighted average cost of capital and gearing ratio of the company has been calculated. And the recommendation has been given to the company about a better optimal capital structure position where the risk and the cost of an organization could be balanced and the performance of the company could be managed.

Company overview:

Altium limited was formerly known as Protel, until 2001. It is an Australian company which has been register in the Australian stock exchange. The company offers the software of PC based electronic designs for the engineers who plans and designs the circuit boards. Headquarter of the company is in Sydney, Australia. The company has diversified its market into various countries such as Australia, United Kingdom, Japan, China and various other markets. The main products of the company are Altium designer, TASKING, vault, Octopart, CircuitMaker, Upverter etc. In financial year 2016-2017, the total turnover of the company was $ 66 million. Company has been founded in 1985 (Home, 2018). Altium limited is operating its business under the industry of EDA, Embedded system, FPGA, Printer circuit board. The capital structure of the company explains about riskier position.

Calculation of WACC:

Weighted average cost of capital is the average cost of an organization which is expected by the investors of the organization to compensate. The weighted average cost of capital of an organization is calculated after evaluating cost of debt, cost of equity and cost of preference share of the company. Cost of all the sources through which company has raised the long term sources are multiplied with the total portion of that source in total capital to calculate the weighted average cost of capital of an organization. Cost of capital explains that what the total cost of an organization is. WACC is a better base for the organizations to evaluate any investment opportunities. If the internal rate of return of the investment opportunity is higher than the WACC than only the project should be accepted by the company. Below is the formula of WACC:

WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

Where,

E = Total book value of the company's equity
D = Total book value of the company's debt
V = Total book Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T= Tax Rate (Fan, Titman & Twite, 2012)

In the report, WACC of Altium limited has been calculated; the application part of WACC is as follows:

Cost of equity:

Cost of equity is total amount which is expected by the inventors of the company to compensate against their investment amount. Cost of equity is the return which is paid by the company to its equity investors as dividend amount (Margaritis & Psillaki, 2010). Cost of equity is the minimum amount which must be paid by the company to its stockholders. Cost of equity amount offers a base to the investors of the company to evaluate that whether they want to make any investment or not.

In case of Altium limited, the cost of equity amount has been calculated on the basis of CAPM model.

CAPM model:

CAPM model is one of the costs of equity valuation models. CAPM models take the concern of risk free rate, market premium rate and the beta of the company to measure the total cost of capital. In the report, risk free rate of the company is 2.41% (Bloomberg). This is the T bill yield of the Australia of last 5 years. It explains about the minimum return of the country without any risk. Further, the market premium amount is 8% and the beta of the company is 0.87, which has been calculated on the basis of historical data of Altium limited and the index (Yahoo finance, 2018). On the basis of above data the below calculations have been done which explains that the cost of equity of the company is 7.15%.

Calculation of cost of equity (CAPM)

RF

2.41%

RM

8.00%

Beta

0.847

Cost of equity (Ke)

7.15%

Cost of debt:

Cost of debt is total amount which is expected by the debt holder of the company to compensate against their investment amount. Cost of debt is the interest amount which is paid by the company to its debt holders as investment amount. Cost of debt is the minimum amount which must be paid by the company to its debt holders. Cost of debt amount offers a base to the investors of the company to evaluate that whether they want to make any investment or not (Reuters, 2018).

In case of Altium limited, the cost of debt amount has been calculated on the basis of after tax calculations. The interest rate has been found in the annual report and the tax % has also been found in the annual report of the company. Thus, the cost of debt of the company is 3.85%.

Calculation of cost of debt

Outstanding debt

18

interest rate

5.50%

Tax rate

30.0%

Kd

3.85%

(Annual report, 2018)

WACC:

On the basis of the above evaluation and the study, it has been found that the total debt and total equity of the company is $ 18 and $ 182 in 2017. It explains that total weight of debt amount is only 9% and the equity weight of the company is 91%. It further explains that the debt and equity weighted average cost of the company is 0.35% and 6.5%. It explains that the WACC of the company is 6.85%.

WACC calculations of Altium Limited (Book Value)

(Amount in millions)

Price

Cost

Weight

WACC

Debt

18

3.85%

0.09

0.35%

Equity

182

7.15%

0.91

6.50%

200

Kd

6.85%

(Morningstar, 2018)

Calculation and difficulties of gearing ratio:

Gearing ratios are the financial metrics which evaluates the long term liabilities of an organization on the basis of total capital employed of the organization. Gearing ratio is calculated to measure the relationship among the long term liabilities of the company and the total capital of the organization. It explains about the proportions of long term liabilities in context with the total capital.

In case of Altium limited, it has been found that the total gearing ratio of the company is 9% which explains that the long term liabilities of the company are just 9% of total capital of the organization.

Gearing ratio= Long term Liabilities/ capital employed

Capital Employed = Total assets- current liabilities

Calculation of Gearing ratio

Long term liabilities

18

Current liabilities

74

Total assets

274

Gearing Ratio

9.00%

(Annual report, 2018)

No difficulties have been occurred while calculating the gearing ratios as the entire data was easily available at the Morningstar (2018).

Findings:

Capital structure is an approach to identify the business activities and the risk and cost position of an organization, capital structure of an organization affects the entire profitability level and efficiency of an organization. Capital structure of an organization explains about the risk and the cost position of an organization (Lemmon & Zender, 2010). It explains that capital structure of an organization must be in a manner that the cost and the risk position of the company could be lower.

In case of Altium limited, the WACC calculations and the gearing calculations have been done to measure the capital structure and the performance of the comapny. On the basis of above evaluation over WACC calculations and Gearing ratio calculations, it has been found that the capital structure of the organization is not at all optimal. The debts of the company are just 9% whereas the equity of the company is around 91%. Further, the cost of debt of the company is 3.85% and the cost of equity of the company is 7.15%. It explains that the cost of equity of the company is quite higher than the cost of debt of the company.

Further, the weighted debt and equity weighted average cost of the company is 0.35% and 6.5%. It explains that the WACC of the company is 6.85%. On the basis of gearing ratio and WACC, it has been concluded that the capital structure position of the company is not at all good. The company is suggested to enhance the level of debt amount to make an optimal capital structure.

Recommendation and conclusion:

To conclude, the cost of debt of the company is 3.85% and the cost of equity of the company is 7.15%. On the other hand, the weight of debt amount is 9% and the weight of equity amount is 91%. It explains that the cost of debt would be very lower due to lower cost as well as lower weight whereas the cost of equity would be very higher because of high cost of equity and high equity weight in the capital structure of the company. The weight and the cost factor explains that the company’s position is highly risky as well as the cost of the company is also higher. It is recommended to the company that the capital structure position of the company is not at all good. And thus the company must enhance the level of debt amount to make an optimal capital structure.

Reflection:

I have found through this study that capital structure is still a puzzle for the financial analyst, investors and the financial managers of an organization. It is quite tough for an analyst to evaluate the better optimal capital structure of an organization. However, in normal scenario, they agree that the optimal capital structure is the position where the cost and the risk level of an organization is balanced. I have learnt various new points and analysis techniques on the basis of this report. The report paper has clear my mind about the capitals structure theories.

Firstly, the WACC calculations have been done to measure the total cost of the company. For calculating the WACC of the company, accounting values have been taken into concern due to the fact that accounting amount is less variable than the market values. However, the market figures explain that the total cost of debt of the company is 7.12% as the market price of equity is higher in the market.

CAPM model has been used to calculate the cost of equity. This model take the concern of risk free rate, market premium rate and the beta of the company to measure the total cost of capital. In the report, risk free rate of the company is 2.41% (Bloomberg). This is the T bill yield of the Australia of last 5 years. It explains about the minimum return of the country without any risk. Further, the market premium amount is 8% and the beta of the company is 0.87, which has been calculated on the basis of historical data of Altium limited and the index.

Further, the interest rate has been found in the annual report and the tax % has also been found in the annual report of the company. It reflects that almost all the figures which have been used in WACC model and Gearing ratios have been used after calculating the related factors.

References:

Abor, J. (2005). The effect of capital structure on profitability: an empirical analysis of listed firms in Ghana. The journal of risk finance, 6(5), 438-445.

Annual report. (2018). Altium Limited. (Online). Retrieved on 12 May 2018 from:

Bloomberg. (2018). Australian bonds and rates. (Online). Retrieved on 12 May 2018 from:

Fan, J. P., Titman, S., & Twite, G. (2012). An international comparison of capital structure and debt maturity choices. Journal of Financial and quantitative Analysis, 47(1), 23-56.

Home. (2018). Altium Limited. (Online). Retrieved on 12 May 2018 from:

Lemmon, M. L., & Zender, J. F. (2010). Debt capacity and tests of capital structure theories. Journal of Financial and Quantitative Analysis, 45(5), 1161-1187.

Margaritis, D., & Psillaki, M. (2010). Capital structure, equity ownership and firm performance. Journal of banking & finance, 34(3), 621-632.

Morningstar. (2018). Altium Limited. (Online). Retrieved on 12 May 2018 from:

Reuters. (2018). Altium Limited. (Online). Retrieved on 12 May 2018 from:

Yahoo Finance. (2018). Altium Limited. (Online). Retrieved on 12 May 2018 from:

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